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VC Funding Begins To Dry Up

Venture capital investment declined in the third quarter to the lowest level in almost two years, and funding to Internet companies plunged 36% in just one quarter. The much-anticipated slowdown in VC investment has begun.

VCs invested $7.1 billion in startups and emerging companies across a range of industries in the third quarter of 2008, a 7% decline from the second quarter when $7.7 billion was invested, according to a just-released report from PricewaterhouseCoopers and the National Venture Capital Association that's based on data from Thomson Reuters.

Given the declines in the stock market, turmoil in the financial sector, and tight credit, Silicon Valley has been bracing for the ripple effect on entrepreneurs and new companies. The numbers show that funding was tightening even before September's financial-market craziness, leaving many experts believing things will only get worse. "We do expect a dip in investing over the next several quarters," says Tracy Lefteroff, global managing partner of PWC's VC practice.

Here's how the numbers break down:

• $7.1 billion went into 907 deals in 3Q 08. That's the lowest level since the fourth quarter of 2006, when $6.3 billion was invested. Still, that $7.1 billion was within "historic norms," according to the report.

• Biotech companies got the most money, $1.35 billion, followed by software companies with $1.34 billion. Software had the most deals of any industry, with 214 companies receiving funding.

• Among Internet companies, $1.1 billion went into 194 deals, a sharp decline from 2Q '08. What happened? Faysal Sohail with VC firm CMEA Ventures explained the decline, in part, as being a result of investors being more selective about giving money to similar companies. He also said less capital is required for Web companies to get going, though that can't explain such a dramatic quarter-to-quarter drop.

• Money going to first-time financings dropped 12% to $1.5 billion from the previous quarter, and the number of first-time deals dropped 20% to 259.

• The newest of companies -- seed and early-stage -- accounted for 350 deals worth $1.7 billion, compared with 378 deals worth $1.8 billion in 2Q.

The key question is, What happens next? Conventional wisdom settling over entrepreneur land is that VC funding will become even more scarce and that a growing percentage of available funding will go to later-stage companies, which are finding it impossible to exit into the IPO market.

Translation: Even less money will be available to brand new startups. Says NVCA president Mark Heesen, "There are clouds on the horizon."

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